Tag Archives: US Stock Market

(Revised) Learning from the Bull Market

Many investors have suppressed the reality of the stock market crash of March 9, 2009. In March 2014, five years after the crash, investors have been pouring their money back into stocks. $172 billion has been added to U.S. stock mutual funds and exchange-traded funds- more than had been withdrawn from 2008 to 2012 combined. Another $24 billion has been added in 2014.

According to this Wall Street Journal article, it has taken an average of 3.3 years for stocks to surpass their high set before the typical bear market began. “Unless you think the next bear market and subsequent recovery will be worse than average, sticking with stocks is the best response to the certainty that, sooner or later, the current bull market will come to an end”. This being said, it is necessary to look at the entire picture. After the 1929 stock market crash, the Dow didn’t surpass its 1929 pre crash peak until 1954- 25 years later. Therefore, the Dow paints a distorted picture of recovery. Firstly, it only represents 30 stocks (the stock must be a leading, widely held stock in its industry). Second, it doesn’t include dividends- this was a big portion of stocks’ total return in the 30s. Third, a big portion of declines in the Dow disappears after adjusting for deflation.

Even though the average has taken 3.3 years, it is understandable as an investor to be complacent. This WSJ article suggests that investors need to reflect on how a bear market affected their behavior in the past and factor that into how it should affect their thinking now. What is a bear market? WSJ defines it as when stocks fall 20% from a peak. A bull market is defined as when stocks rise 20% off a low point. In sum, this article cites stock market events that have happened in the past and suggests how these past actions may affect investors decisions in the future. Advice is suggested regarding being skeptical of experts, remembering what the recession felt like, limiting risk-taking, being wary of the labels “bull market” and “bear market”, and questioning performance figures.

To sum up these arguments, in terms of being skeptical of experts- pick the ones who seem aware of the uncertainty of their predictions and are willing to change their minds. An “expert” who once had a correct prediction won’t necessarily be right the next time around. In terms of remembering what the recession felt like- if an investor stayed put during the crisis, then he or she should stay put now. If an investor sold during the crisis, then this investor will almost certainly sell again if the market takes another steep fall. Limiting risk taking- investors are better off keeping a smaller amount in stocks and sticking with this allocation in good times and bad. Being wary of labels- as implied earlier, an average is not a very good measure of performance. It’s better just to look at whether or not stocks are valued more highly than in the past. Now, stocks are trading at about 25 times average earnings. The historical average is 16.5. Lastly, questioning performance figures- “Research by finance professor Raghavendra Rau of the University of Cambridge and his colleagues has shown that investors flock to funds whose five-year returns improve when a bad month drops out of the beginning of the sequence.” Fund companies often raise fees and take advantage of “improved” performance by dropping the month of February 2009 and starting at March 2009. Clearly, skipping this pivotal month makes returns seem much more appealing.

In recent news, there have been comparisons of the current stock market to that of the 1990s– especially the mid nineties. The mid-nineties showed big gains in stock despite slow growth in the economy. Compared to the stock market right now, we can see that the economy has been sluggishly making its way back to pre-crisis levels. Job creation has been picking back up slowly, but steadily. Also, Janet Yellen projects short-term interest rates to increase in mid 2015. The Nasdaq and Dow Jones haven’t faired as well as the S&P 500 this year, but losses in these indices haven’t been extreme. Some say the bull market is showing signs of fatigue, but the S&P 500 has rose nearly 30% and is up .89%. Back in ’94, stocks fell but then quickly recovered when the Federal Reserve rose interest rates. We can see the same similarity today as stocks were down shortly after the recession but are now starting to pick back up. It is not unreasonable to claim that these gains will also extend to the future even as the Fed expects to raise interest rates in the middle of next year.

On the other hand, there are still differences between the current stock market and the stock market of the 90s. The most notable difference is the magnitude of the damage from the recent financial crisis. This may very well cause a more uncertain outcome. Although stocks may pick up when the Fed raises rates, the Fed itself is not completely certain of whether or not it will have the ability to raise them from near-zero levels in just about a year from now. A couple more big similarities between now and the 90s is that there weren’t many pullbacks (until the tech bubble) and we are also in a post-financial-crisis period with a ‘jobless’ disinflationary recovery. From ’95 to ’98, the S&P 500 rose an average of 28% per year. Now that we’re seeing 30% gains, the situation is somewhat similar.

I feel that the situation is definitely similar, but we cannot forget the difference in crisis that led to this bull market. The crisis of the late 80s was much less of a shock than the recent great recession. This makes it harder to predict how stocks will perform in the future because stocks tend to move in line with economic improvement. However, safer comparisons that we can make between now and the 90s are the condition of the job market and the relatively slow growth- I wrote a post about the current slow economy growth earlier this week (click here). Connecting these two posts, I believe that we should still anticipate stock gains in the future. Even though the job market is not doing as well as expected, I think the economy will recover further and further away from recessionary levels as long as the Fed guides inflation back up to 2% and stays course with the bond-buying program. As I mentioned in the other post, business profits are up and businesses have been investing. This is a good sign for consumers because it indicates that businesses and consumers are both more confident that each will do their part to benefit the other. Therefore, along with business profits we can project stock market gains.

Projecting Stock and Bond Returns

While reading A Random Walk Down Wall Street, the part that I found most interesting was Malkiel’s explanation of understanding returns from stocks and bonds. Later, a history of the stock market is provided and general tips on investing are given. In the long run, the returns from common stocks are driven by 2 things: dividend yield at the time of purchase and also future growth rate of earnings and dividends.

Breaking down the actual value of a stock, as we have covered in class- a dollar received tomorrow is worth less than a dollar today. Thus, a share of common stock is worth the present (discounted) value of its stream of future dividends. Moreover, if a company pays smaller dividends today and reinvests more of its profits, the investor anticipates this reinvestment to bring a greater stream of dividends in the future.

Although dividend yield and growth rate is essential for projecting returns- over a shorter period of time, the price-earnings multiple also becomes a critical part of the equation. The price-earnings multiple deals with the change in price-dividend. In times of optimism, the price dividend multiple has been over 80. In times of pessimism, (like the early 80s) this multiple has been as low as 8. The price-earnings multiple is influenced by interest rates. When rates are low, price-earnings multiples are high. When interest rates are high, stocks tend to sell at low price-earnings multiples. In terms of bonds- when interest rates rise, bond prices fall and existing bonds become more competitive compared to the ones currently issued at higher interest rates. When interest rates fall, bond prices increase.

Malkiel states that many analysts question whether dividends are as relevant as they used to be. Many argue that more firms prefer distributing their growing earnings to stockholders through stock repurchases rather than dividend increases. Firms that buy back stock tend to reduce the number of shares outstanding, thus, increasing earnings per share and share price. This is how buybacks create capital gains. It is also in the shareholder’s benefit in that the tax on capital-gains can be deferred until the stock is sold. This tax is only a fraction of the income tax rate on dividends.

The chart below gives a view of the stock and bond market in the US from 1946 to 2009. It is interesting how the rates of stocks, bonds, and inflation are compared to specific economic events of each time period.

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The time period from 1946 to 1968 is described as the Age of Comfort. These were the years of growth after World War II. As can be seen by the graph, there were much better returns from stocks than bonds during this period. This can be attributed to stimulus from Kennedy’s tax cut in the 60s and also the increase in government spending due to Vietnam. During this time, the economy was robust and employment was high. A big reason why the bond market didn’t do so well is because the US pegged their long term rates at no more than 2.5%. This policy allowed the government to finance the war cheaply with low-interest borrowing.

The time period from 1969 to 1981 is described by Malkiel as the Age of Angst. A few problems of the time were accelerating inflation because of Vietnam and rising oil prices due to OPEC in ’73-’74. Given that inflationary levels were above 10%, many citizens believed that the economy was out of control. After tight monetary policy from Paul Volcker, the economy suffered a sharp decline and high unemployment- however, the economy started to get back on track.

The time period from 1982 to 2000 is described as the Age of Exuberance. The baby-boomers had matured, peace returned, and a non-inflationary economy set in. As can be seen in the graph, both stock holders and bond holders enjoyed unusually generous rates of return. One of the reasons for the boom was the internet bubble (dot-com bubble) from ’97-’00 due to rapid growth in the internet sector.

Lastly, the most recent time period is referred to as the Age of Disenchantment. This is the time period of the stock market that most of us are familiar with. It was one of the worst decades ever recorded. Real estate dropped and destroyed the value of many mortgage-backed securities. As unemployment levels reached double-digit levels in October of 2009, many of us knew or experienced parents losing jobs and dealing with home foreclosures. However, If I have learned anything from looking at these stock market figures over nearly the past 70 years, I have learned that after recession comes prosperity. As I am released into the work force, I plan to approach the situation with an optimistic mindset. It is great to see that hiring levels are picking back up and in the near future, I hope that the US will be able reach and sustain long-term natural rates of inflation and unemployment.

Stock market rally does not mean we’re recovering

January was a difficult month for markets everywhere with all the chaos in emerging markets, disappointing jobs reports, and the Fed’s continuation on QE tapering.  Several of these factors have contributed to what analysts and pundits predicted as a much needed market correction and a flight to quality as investors would realize not everything they’ve put money in is worth keeping for the medium run.

However, February has seen something of a recovery as the S&P looks to be nearing some record highs.  According to the Wall Street Journal, investors might be acting less cautiously.  The reason being that they already expected the markets to decline but after observing some of the decline unfold, realized that there was more upside than down.  As a result, investors now feel that it is a good time to buy. Another potential reason, as cited by CNN Money, shows that this was a vote of confidence in Janet Yellen’s recent statement indicating that there wouldn’t be any further surprises.

Either way, it is a bit unusual though that investors have experienced this change of heart though and the Wall Street article above serves to highlight this fact by noting that analysts have cut predictions and lowered estimates for 760 publicly traded companies and only raised it for 457 and FactSet, a data research company reports that 81% of companies will fail to meet its projected first quarter earnings.  So in that sense, a stock market rally does not mean that everything is going well because many still believe a market correction, like the one experienced in 2011, is still likely to occur.

The second point of worry is that many investors seem to anticipate somewhat dramatic drops as evidenced by the article.  Seth Masters, chief investment officer at Bernstein Global Wealth Management, had this to say to WSJ.

It’s easy to come up with all sorts of scenarios, where we would have a 10% correction at any time

Mortimer’s remark seems somewhat flippant and doesn’t really reflect his own optimism about the direction of stock markets.  Another remark by Jeff Mortimer, president of BNY Mellon indicates something different.

“It clearly seems that a change in psyche is transpiring as you pass from January to February,” […] You are going to get volatility this year”

Although Mortimer is quoted in the Wall Street article as being optimistic, This particular remark seems somewhat ambiguous and contradicts his earlier optimism about growth before and after dividends which would make stocks a more valuable investment than bonds. With so many firms not expected to meet their projected Q1 earnings, it does leave the door open to another dramatic decline.  Whether that is enough to trigger fears of a market reaction similar to what happened in January remains to be seen. January might have been the perfect storm, but it may not mean the waters will remain calm in the foreseeable future.

U.S. Stock Market 2014- to worry or not to worry?

Recently, the Dow Jones Industrial Average has been down 5.3% from its Dec. 31 record. Most market managers expect the market trouble to hang around for a while and also believe that things will not get much worse. However, there are still two sides to the debate. The other side that predicts a volatile market still has strong reasons for their claims.

Furthermore, the largest contributing factor to the performance of the stock market is the economic trouble that many developing countries are facing. If conditions end up worsening in emerging market economies, markets could fall further. However, few professional investors seem to share these fears. They view the pullback as a natural occurrence- like a storm that hits about every year. Even though the Dow hasn’t fallen 10% since the middle of 2011, investors are even talking about percentages larger than 10% without sounding too upset because they anticipate that stocks will finish with gains at the year’s end.

The optimists “generally believe the U.S. economy has cut costs and made other adjustments that will let it keep rebounding, even as developing countries suffer because they aren’t prepared yet for a world with softer demand for their commodities, components and other exports”. These money managers encourage their clients to buy even in bad conditions when prices fall. Overall, the notion of investors in the WSJ article was that they were not worried about long-term conditions. Their perspective was also justified by the fact that if markets continually go up, you will get bubbles. They believe that it is the occasional weakness that keeps them on their toes.

Moreover, as a reaction to the anticipated stock market risk, treasury-bond prices have risen because investors have ran to them for safety. With the Fed’s recent reduction in financial stimulus, many investors think interest rates will rise on future bonds- which means the prices of existing bonds will decline.

To the contrary, those who anticipate the stock market to become less-bullish in the near future make a valid argument. Much of the risk is contingent on the conditions in emerging market currencies. This was a prime reason to why the Dow had its worst week since 2011- investors fled risky assets. Also, the value of the Argentinian peso plunged and China’s huge manufacturing sector has been showing signs of weakness. Overall, I personally believe that volatility decline in developing markets will be the key factor leading investors to buy again.

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Buy More Assets and Print More Money was the slogan that Professor Kimball used in his blogpost to explain possible ways to stimulate the economy in recession. Rather than highlighting the endless potential on “Buy More Assets” aspect, I would like to focus on where we stand on the “Print More Money” side of the story and discuss its ramifications on a global scale.

Much debate had been going on about Ben Bernanke’s Quantitative Easing (QE) and its tapering. The quantitative easing in short just means that Federal Reserve will purchase large volume of bonds so that more money would be floating in the economy, working as a strong stimulus. Ben Bernanke’s proposition to “taper” was to reduce the size of the bond buy-back program on the belief that the economy is regaining its strong hold. Bernanke announced his plan on May 22nd of 2013, and hinted that tapering is a viable option. The tapering, as we all know, did go through. Just not on schedule.

I still remember the excitement my roommate had when QE tapering in third quarter did not happen. He is a trades on the market, with a focus on macro investing. Ever since Bernanke’s announcements, second half of US stock market experienced a turmoil in anticipation of less money being injected into the market. When the tapering did not go through, bullish market made my roommate a quick fifteen-hundred dollars. The market rallied almost 30% last year, which is highest since 2009.

The tapering did not happen until December 18 of 2013 and it has been almost a month since the QE was downsized. What are some of the results we see around the world? It seems like Ben Bernanke’s decision was right. Despite the tapering, US stock market is doing quite well. US economy indeed is regaining its foothold.

How about the other parts of the world then?

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The decline in the capital inflow to many countries raised the risk among some developed countries. According to the Wall Street Journal,

Mutual fund flows and portfolio investment drop the most, with bank lending and foreign direct investment largely unaffected. Growing demand from the world’s largest economy, the U.S., helps offset the rise in borrowing costs, the bank says.

The bank, however, doesn’t rule out a faster exit, saying a 100-200 basis points spike in interest rates is possible if the Fed accelerates its timetable or overshoots its economic targets. That could cut capital flows by 50%-85% for several quarters.

The real concern of a sharp tightening in capital flows, says Andrew Burns, the chief author of the bank’s flagship report, is where economies have large trade deficits, high private sector indebtedness, and big foreign currency exposures.

Historically, become-rich-by-making-neighbors-poor method proved to be a dangerous approach in the macroeconomic world. While US should be alerted in the general welfare of the world economy, the other parts of the world should also be mindful that there is always competition. Although it was only been a month since the tapering, bond and portfolio investors should be very mindful of the heightened risks in some of the developing economies as they may be vulnerable to the worries mentioned above.